In 2009, former Fed chair, Paul Volcker, said that the ATM has been the only useful innovation in banking over the previous 20 years. How much innovation have banks done since? Does the current market downturn create an opportunity for them to catch up? I would argue so, yes. If they want to of course. Brendan Greeley, wrote in the FT over the weekend that banks choose not to innovate and provide consumers with better products, because the returns are terrible. They’d rather continue with expensive credit cards, difficult and costly transfers, huge fees on overdrafts, and unnecessary fees in general for very poor digital experiences – because it boosts margins on low-balance accounts.

Banks have done a very bad job at meeting the financial needs of their clients. Only 1% of Americans see banks as crucial to their financial success. FinTech companies have stepped in to fulfil these unmet needs, slowly taking more and more market share from incumbents - financial technology and payments companies have gained a quarter of the aggregate value of the financial service industry over the past decade.

The market downturn and tumbling tech stocks present a strategic opportunity for banks to regain ground, protect their market share and catch up to the fundamental shifts in technology and digitization, which (most) lag behind on.

What’s Happening in the Markets

FinTech stocks have tumbled over the past year. An index assembled by aperture indicates FinTech stocks are down 60% YoY compared to the NASDAQ 100 which fell 20% over the same period.* Moreover, there has been a pullback in public valuations. In June 2020, NTM EV/Revenue multiples for FinTech were 34% higher (at 7.5x) than the mean for NASDAQ 100 constituents (5.6x). After equalizing in June 2021 at 5.5x, public FinTechs are now trading around 2.3x NTM EV/Revenue compared to a mean of 4.5x for the NASDAQ 100. This is a significant adjustment from 7.5x to 2.3x EV/Revenue over 2 years – a clear depression in public valuations.

Private market FinTech valuations are also taking a knock. Growth rates are a massive driver behind private valuations since they are extrapolated far into the future and with an expected economic slowdown comes an inevitable multiple compression. Klarna, Europe’s star FinTech, is expected to cut a third off its valuation, based on recent funding discussions.

FinTech private fundraising activity remains fairly strong. Crunchbase data suggests, $24.1B has been raised year-to-date in seed, early and late stage venture compared to $22.7B in the same period in 2021. Seed stage FinTech has attracted $200M more in the first 5 months of 2022 compared to the same period last year. The funding story for the remainder of 2022 is likely to be less rosy. The severe contraction in public FinTech stock valuations will take 3-6 months to reflect in the private markets. Moreover, the recent external pressures and macroeconomic fears are likely to feed through to FinTech fundraising.

Research and investment banking boutique, Rosenblatt Securities, highlights here, that the price performance of public market FinTechs has more do with investors souring over growth and tech stocks and less a reflection about the long-term value proposition of FinTechs. Likely it’s also a reflection that investors are just more realistic about growth prospects and valuations in turn. Point being, it has more do to with valuations, and less to do with the intrinsic value of FinTechs. The current investor trepidation has more to do with broad macro concerns about ongoing rate increases due to central banks’ tightening policies and the risk of an economic hard landing and possibly a prolonged recession.

Incumbents’ Time to Shine

During a recent interview at Davos, UBS CEO, Ralph Hamers, commented that “the market value of (FinTech) companies might be under question now, but the business models are here to stay. [Because these are] technology business models that are supported by demographics and accelerated by client behavioural change”. These behavioural changes include increases in online spending, shifts in engagement channels, attitudes towards buying financial services online, diminishing trust towards financial institutions and the need to be served digitally. His comments echo those of Credit Suisse Chairman Axel Lehmann, who said “valuations are down and a shakeout is happening, but the fundamental trends in technology and digitization will continue to impact business models.”

Now is the perfect time for strategic acquisitions. Not only is it a good time for incumbent financial institutions to adapt to the changing landscape, but also the next few months will likely mark some of the cheapest prices for FinTech in a while. As FinTech’s start to lay off staff, some will inevitably not have enough cash runway to survive and can be acquired cheaply.

Why Now?

McKinsey found that companies in cyclical industries could more than double their shareholder returns (relative to actual returns) if they acquired assets at the bottom of a cycle and sold at the top. Carlyle co-founder David Rubenstein also notices the opportunity at hand, and says there is an opportunity for investors to go in and “buy at the bottom.”

Companies that invest wisely when times are bad typically outperform peers. Capital expenditures for the 500 largest US corporations over the past 45 years are highly correlated with prior-year profitability. When profits are high and funding is readily available it’s easy for companies to invest in capital projects and it’s a hard cycle to break. Companies that can time their capital expenditures and asset purchases to invest countercyclically typically outperform their peers.

Buy versus Build

Forbes describes the urgency, and trade-off, well in this article: “Banks need to act now if they want to participate in accelerating consumer and technology trends or simply to defend their market share. They can build, using many of the plug-and-play applications on the market, “but they require enormous ambition, focus, and a clear vision. Or they could do an acquisition, which could provide a way for late entrants to catch up.”

Building the right solutions, assuming these can be designed in-house, will likely be more costly than picking up the right one in the current market. Furthermore, buying a proven service already in market is significantly less risky given both the challenges of product innovation within an existing financial institution, as well as the market risk of the product not being well received by consumers.

Incumbents can now acquire the right FinTechs, at reasonable prices, to:

• Acquire skills and technology faster or cheaper than they can be built
• To guard against digital disruption and future-proof their business
• Acquire a new generation of customers along with the know-how on serving those customers
• Gain a competitive advantage relative to less ambitious, or brave, peers
• Acquire great products from a companies that don’t have the resources to go to market
• Accelerate go-to-market with additional resources and/or access to new geographies
• Challenge the DNA of the existing organization and start to change the culture 

Picking Properly

J.P. Morgan is going all out on payments and see winning in payments as their strategic imperative. The bank made nearly 20 investments in the FinTech space in 2021. The same year, more than 65% of J.P. Morgan Chase accounts were opened online. But succeeding in the future of banking will take more than “winning in payments” and a solid online offering. Banks should think about how they can serve all the financial needs of consumers (such as risk management, budgeting, and investing) in a way consumers want to be served, digitally, frictionlessly and via channels where they live their daily online lives. It’s about much more than just payments.

Incumbent financial institutions can learn from these tech companies that took advantage of the dotcom bust in the early 2000’s and acquired companies to protect market share and speed up go-to-market. Cisco acquired 71 companies between 1993 and 2001. Their revenues increased from $650m in 1993 to $22b in 2001. By 2001, 40% of their revenues came from these acquisitions. Google bought Android, possibly the most value accretive technology acquisition of all time, when valuations were still depressed in 2005.

There is consolidation coming in the industry and the incumbents brave enough to act now have the opportunity to recapture market share, and catch up to the lack of innovation of the past decades. Hopefully we'll see more than "ATM-innovation" as a result.

Notes:

*Price performance as at 20 June, 2022. The FinTech index assembled by aperture is an equal weighted index.